The Benefits of Reserve Diversification

Yesterday was an official ‘bank holiday’ but apparently most of the WorldMarkets customers were unaware, as our phones were surprisingly busy. Trading in the currency markets was substantially lighter than usual, and with no data releases in the US, the dollar drifted sideways throughout the day. The European currencies were slightly higher versus the US dollar, the Asian currencies were lower versus the US dollar, and the commodity-based currencies were mixed.

European currencies were helped by good news over the weekend as Poland ratified the drafted EU constitution (referred to as the Lisbon treaty). But one big hurdle still remains: Czech President Klaus is refusing to sign the treaty, even though the Czech government has approved it. The Czech President, who is against the EU, is hoping to stall until after the British election, which must be held by June of next year. David Cameron, the Conservative leader, has pledged to hold a referendum on the treaty if his party is elected. This would throw the EU constitution back into question, so EU leaders are putting major pressure on the Czech President. While the pursuit of this last signature makes for good drama, I believe the EU constitution will be ratified, and the European Union is not in any immediate danger of falling apart.

In fact, the euro (EUR) has quickly become one of the preferred investments for central banks who are looking to diversify out of US dollars. As Chuck wrote in yesterday’s Pfennig, the latest data shows that central banks placed 63% of new reserves into euros and yen (JPY) in April, May, and June. Foreign currency reserves were increased by $413 billion during the last quarter, the most since 2003. In the past, a majority of these reserves would have been invested into US dollars, but central banks are now shying away from the greenback.

Recently, the roles of the dollar and the euro/yen have been reversed. Previously 63% of new reserves were placed into US dollars, but lately that number has fallen to just 37%. As Chuck and I have written in recent Pfennigs, the current administration has no interest in supporting the US dollar, and global central banks seem to be fearing this lack of support. According to the data reported by Bloomberg, the dollar will likely remain under selling pressure for some time to come. Despite last quarter’s move away from the greenback, central banks still hold over 62% of their foreign currency reserves in US dollars, leaving plenty for future sales.

Some of the largest pools of reserves are being held by China, Japan, Russia, and India. Both China and Russia have repeatedly called for the creation of a ‘new’ reserve currency, so their moves out of US dollar come as no surprise. China, which controls $2.1 trillion in foreign reserves is the largest holder of US debt with over $800 billion invested in US treasuries. Investors would be wise to take notice of where these countries are moving their reserves. Pulling reserves away from the dollar will continue to rally the alternative currencies of the euro and yen; and will also put upward pressure on the price of gold, which is another attractive alternative for reserves.

As I mentioned above, leaders in the UK will be forced to call an election by June of next year. Prime Minister Gordon Brown has been trailing Conservative leader David Cameron in opinion polls and the sagging British economy isn’t helping his position. Mr. Cameron has been calling for an end to the ‘quantitative easing’ and a focus on the ballooning deficits. The Treasury expects its deficit to touch £175 billion this year, about 12% of national income and the most in the Group of 20 nations. Brown wants to sell assets including the government’s stake in the Channel Tunnel and increase taxes in order to halve the budget deficit in the next four years. I have to side with the conservatives and Mr. Cameron on this one. I just don’t see how increasing taxes and selling off assets in order to continue to pump money back into the economy is a positive long-term strategy.

What scares me is that Prime Minister Brown’s plan has the stamp of approval of economists at Goldman Sachs. Readers know the influence the folks over at Goldman have on our administration. The US followed the Bank of England down the path of ‘quantitative easing’, and we will pay the price for these inflationary policies in the not-to-distant future. Why jeopardize the long-term health of your economy for short-term growth? But politics leads to some poor decisions, and Brown can’t risk falling back into a ‘double dip’ with elections coming up around the corner. The same can be said of the US administration, with mid-term elections looming in 2010.

The pound sterling (GBP) fell to its lowest level in several months versus both the US dollar and euro yesterday as speculation of an increase in the ‘quantitative easing’ programs ran through the markets. The UK inflation rate dropped in September by more than forecast, to the lowest level in five years. With inflation continuing to run below the radar, pressure will continue for the BOE to pump more newly created money into the markets through asset purchases.

Questions over Brown’s economic policies and the uncertainty of the upcoming election will certainly keep up the selling pressure on the pound. I read a research report over the weekend which predicted the pound sterling would continue to drop, bottoming out as low as $1.45 if Brown’s Labor party were able to hold on in the upcoming election. On the other hand, the report predicted the pound would rise to $1.85 by the end of 2010 under a Conservative Party win.

The Asian currencies were the worst performers yesterday, selling off on speculation central banks would take advantage of the light markets to intervene. This is a perfect example of how ‘jawboning’ can work. Asian central banks have been expressing concern on the recent strength of their currencies as compared to both the US dollar and Chinese renminbi (CNY). Since the Chinese have decided to ‘peg’ their currency to the falling dollar, other Asian nations with free floating currencies have been put at a competitive disadvantage. With many traders in the US gone for the holiday, it was a perfect time for some verbal intervention by Asian central banks. The South Korean government said it would intervene to stop excessive volatility, and Taiwan said it would introduce measures to deter speculators. This verbal intervention had the desired effect, and temporarily reversed the ascent of the Asian currencies versus the US dollar.

But overnight, these currencies surged back as the region continues to be the first to recover. Reports released show growth in Malaysia, South Korea, and Indonesia will be higher than previously predicted. Verbal intervention just can’t compete with strong economic reports. The data doesn’t lie, and it shows Asia will continue to take the lead in this global recovery.

The Indian rupee (INR) moved higher after a report was released which showed a big jump in industrial production in India. Output at factories, utilities, and mines jumped 10.4% in August from a year earlier – the largest jump in almost two years. The larger-than-expected move will increase pressure on India’s central bank to begin to raise rates. Central bank Governor Subbarao said last week that India may need to act ahead of advanced economies due to the ‘incipient’ inflation pressures.

While most have predicted a move up during the first part of next year, some now believe we could see a 50 basis point hike as early as the October 27 monetary policy meeting. India has been overshadowed by the growth story in China, but India’s growth is expected to keep pace with its larger neighbor. India also enjoys a more established economic system, a more educated workforce, and a higher standard of living than China. The central bank has reduced taxes on consumer products and imports, and cut interest rates to provide a stimulus worth more than 12% of India’s GDP. If the Reserve Bank does boost rates later this month, the rupee could enjoy a continued rally versus the US dollar.

One of the currencies with the biggest gains versus the US dollar overnight was the kiwi (NZD). Chuck noticed the currency rallying late last night and sent me this from home: New Zealand’s retail sales rose in August at more than twice the pace expected by economists, adding to signs the economy’s recovery from recession is gathering pace in the second half of this year. Sales increased 1.1% from July, seasonally adjusted – statistics New Zealand said in Wellington today. Core retail sales, which exclude car yards, fuel outlets and workshops, rose 1.2%.

I think this just may move RBNZ Governor Bollard to move rates earlier than he had wanted to… But like I said last week in my rant and memo to Bollard, who is known as someone who likes to talk down his currency… “Don’t you want your currency to move higher versus the dollar? Then don’t raise interest rates!” Unfortunately for Mr. Bollard, he’s trying to paddle against the current right now… So, unless he wants to face the music that comes from soaring inflation in the future, he’ll have to raise rates… And suffer through a rising kiwi!

The Daily Reckoning